Financial Times: Comment: Give investors top priority in stock markets

By Eric Noll | Convergex 

As US stocks ride the third-longest uninterrupted bull run in history, the question of whether equity markets are rigged continues to pervade the industry.

Fingers remain pointed at high-frequency traders (HFT) and their use of high-speed trading, with complaints it has put other market participants at a disadvantage. It is no surprise that there is widespread support for an immediate change in market structure to neutralise the advantages given to HFTs.

While HFT proponents say high-speed trading adds liquidity to the market, unfortunately that advantage is often outweighed by the market volatility high-frequency trading may cause as well as the considerable mistrust in their activities.

In their defence, they are just taking advantage of a market structure that allows them to buy and sell stocks ahead of retail and institutional customers who cannot compete on speed. That is the crux of the issue: speed should not be the most important criteria in determining how orders are handled unless we want markets that do not focus on what the real investor needs in the market.

If Wall Street and the Securities and Exchange Commission are serious about wanting “better” markets over “faster” markets and protecting investors, as I believe both are, then they need to support a change in market structure that will adopt new pricing reforms that take away the speed advantage and mandates retail and institutional customer orders above orders from all others.

While best price should take precedence, the current price/time priority order handling rule for stock executions is a pricing system that is detrimental to investors, susceptible to abuse and contributing to the deterioration of market quality.

This year the SEC created the Equity Market Structure Advisory Committee, which I was appointed to alongside other industry veterans, to provide recommendations to ensure that markets operate openly, fairly and efficiently to benefit investors.

For the committee to make an impact, however, it and the SEC need to take actionable steps. Reforming a rule that is little understood but would have a huge impact on the industry and how we treat the investing community is a dramatic step in the right direction.

We cannot continue to give some an advantage and then cry foul when market mishaps occur. It is most important to enshrine both retail and institutional investors above all market participants. Elevate customer orders in all markets ahead of brokers, market makers and high-frequency traders and move the markets to a price-customer order priority system.

To understand how much market deterioration has occurred, take a look at the numbers. We now operate in an environment where liquidity is confined to approximately 100 names accounting for over 80 per cent of US trading activity, and the average trade size is as small as 200 shares.

We need to attract more investors to trade at the exchanges instead of dark pools — but what is the incentive for investors to trade on exchanges if they believe that the current system puts them at a disadvantage?

Since Regulation NMS was introduced in 2007, our market structure has been in constant flux, with high-frequency trading, dark pools and complex order priorities each adding challenges for institutional investors.

I propose that exchanges and other market venues create a simple tiered system for order executions, with customer orders at the top, followed by orders from market makers, and lastly orders from high frequency and professional traders. This sends a clear message that quality of execution is more important than speed.

Detractors will claim this change will be disruptive to markets, hurt liquidity and negatively impact the business models of many market participants. I contend that this change would be a welcome benefit to lit markets, driving traffic back from dark pools which, according to Rosenblatt Securities, account for 16 per cent of US daily trading volume (while total off-exchange volume exceeds 30 per cent).

If done correctly, prioritising customer orders would have the potential to drive institutional investor flow back to exchanges and reduce or eliminate latency arbitrage, potentially increase order execution size, increase liquidity and certainty of execution for customer orders, and most importantly, allow these customer orders to be executed first at the marketplace at the best price.

Moreover, adopting a new order execution priority would only require changes to the language of Regulation NMS and not an overhaul of wider financial regulations. In addition, exchanges already have mechanisms to put this change in place using their customised technology.

While this proposal may have its critics and may require adjustments from the sellside and other market participants, changing order execution prioritisation will be an absolute positive for markets and for investors.

I urge regulators and our industry to begin structuring a process to implement this change in the order priority system, to rank customers at the top, thus restoring investor confidence and ensuring a more robust and fair market structure.